When people hear the word “debt,” they often think of it as a bad thing or associate negative connotations with it. The truth is, some debt can be good.
So, how do you differentiate good debt from bad debt? The difference does not necessarily refer to the amount of money you owe, but rather the reason you owe.
Good Debt Definition
The general dividing factor is whether the debt is something that will add value to your financial position over time or reduce it. Good debt is debt that can help you improve your financial position in one way or another.
For instance, the following are prime examples of what are considered to be good debt:
- Mortgage or real estate loans
- Education loans (student loans)
- Business loans
If you make wise purchasing decisions when buying homes or real estate, over time, the expectation is that real estate will gain value. Buying low in areas where you anticipate market growth allows you to sell high at a later date, once the value of property in the area grows.
Education is an investment in yourself that is expected to pay off in higher-paying jobs in the future. Taking out a student loan to pay for college often equates to higher lifetime earnings.
Borrowing money to expand a business, buy new equipment, or hire new employees to meet growth are all viewed as good reasons to incur debt. Most everyone who takes out a business loan expects the loan to generate positive economic value for themselves and their business.
Bad Debt Definition
Bad debt, on the other hand, is a debt incurred to purchase items that will depreciate or lose value over time. This accounts for a large amount of consumer debt. The following types of debt are considered to be bad debt.
- Auto loans
- Credit card debt (credit card company or retail credit card)
- Revolving debt
In the case of auto loans, depreciation attacks fast and hard. According to Edmunds, you lose nine percent of a new car’s value the moment you drive off the lot. By the end of the first year of ownership, the value drops to 81 percent of the purchase price. By the end of the second year of ownership, it is only worth 69 percent of the purchase price. By the fifth year, the car is worth less than half of the purchase price.
Credit cards and other types of revolving debt work in much the same way. By the time you leave the store, most items have lost some value. Moreover, using credit cards for consumables, like dining out, entertainment, and vacations, adds no long-term value.
What can you take away from this? If you have debt, seek to pay off bad debt first. Then reassess your finances and look for ways to avoid bad debt in the future by paying in cash or saving for big purchases. Reserve credit for items that will add value over time instead of those that will lose it.